Equilibrium Credit Spreads and the Macroeconomy

Abstract

The Great Recession of 2008 offers a primary example of the important role that fluctuations in credit risk play in the aggregate economy. In this paper we explore this link with a tractable general equilibrium asset pricing model with heterogeneous firms. Our model produces realistic movements in risk premia in equity and corporate bond markets and shows how this is an important determinant of aggregate fluctuations following both technology and pure credit shocks. We also show that movements in credit spreads forecast recessions by predicting future movements in corporate investment.

Systematic Risk, Debt Maturity, and the Term Structure of Credit Spreads

“…First, it provides both a theory and empirical evidence for the link between systematic risk and firms' maturity choices in the cross section and over time. It adds to the growing body of research on how aggregate risk affects corporate financing decisions, which includes Almeida and Philippon (2007), Acharya, Almeida, and Campello (2012), Bhamra, Kuehn, and Strebulaev (2010a), Bhamra, Kuehn, and Strebulaev (2010b), Chen (2010), Chen and Manso (2010), and Gomes and Schmid (2010), among others.…”

How does the market variance risk premium vary over time? Evidence from S&P 500 variance swap investment returns

“…This is because VRP is counter-cyclical , Corradi et al, 2013. The slope of the yield curve and the credit spreads have been found to predict the state of the economy (see Estrella andHardouvelis, 1991, andGomes andSchmidt, 2010, respectively). In fact, find that the credit spread drives the VRP dynamics.…”

Credit Risk and Business Cycles

“…Our paper is also related to Gomes and Schmid (2010) who focus on asset pricing implications of credit risk by introducing aggregate shocks and Epstein and Zin preferences into the model of Miao (2005). Miao (2005) studies the interaction between investment and financing decisions in a stationary equilibrium by introducing endogenous debt-equity choice into the industry dynamics model of Hopenhayn (1992) and Hopenhayn and Rogerson (1993).…”

“…Miao (2005) studies the interaction between investment and financing decisions in a stationary equilibrium by introducing endogenous debt-equity choice into the industry dynamics model of Hopenhayn (1992) and Hopenhayn and Rogerson (1993). 6 Both Gomes and Schmid (2010) and Miao (2005) consider defaultable debt contracts with infinite maturity, as in Leland (1994). As in Miao (2005), Gomes and Schmid (2010) assume that firms choose optimal capital structure only in the initial entry stage.…”

“…6 Both Gomes and Schmid (2010) and Miao (2005) consider defaultable debt contracts with infinite maturity, as in Leland (1994). As in Miao (2005), Gomes and Schmid (2010) assume that firms choose optimal capital structure only in the initial entry stage. After entry, firms do not adjust capital structure.…”